Thank You

Error.

Investors seeking emerging-economy juice from Brazil's electric utilities got a jolt last year when the nation's president, Dilma Rousseff, suggested slashing power bills to spur manufacturing and help consumers.

Since last summer, the shares of power outfits such as
C.E.S.P.
(ticker: CESP3.Brazil) and
Eletrobras
(ELET3.Brazil) have dropped by half, as Rousseff demanded rate cuts of 18% for consumers and 32% for commercial customers. But shareholders of other Brazilian utilities have been slow to recognize the populist dangers. A wake-up call sounded on April 19 from a favorite of U.S. investors: São Paulo water utility Companhia de Saneamento Básico do Estado de São Paulo.

Sabesp
as it's known, said it will implement a state-determined rate increase, effective in September, that's barely half what it originally requested from regulators. The news triggered a 6.5% selloff last week in Sabesp's New York–listed depositary shares, which trade under the symbol SBS and, after a split Tuesday, represent three common shares.

Under prior governments, Sabesp got needed tariff boosts. Its shares doubled in the past two years, even as Brazil's benchmark Bovespa index sagged 20%. But in an unhappy conference call on Wednesday, the company said it might have to revise its business plan. "If we arrive and land in August with a tariff increase that's still at a distance from what we think can make this company continue [to be] profitable," said Investor Relations Director Mario Arruda de Sampaio, "we [will] have to go back to the drawing board."

Utilities in Brazil aren't the stable investments that North Americans thought. A careful valuation of the water company's cash-flow prospects might merit a value for its depositary shares only in the mid-$30s—20% below Friday's close of $43.58.

Brazil should be a great place for water-utility investors. Its biggest city, São Paulo, anchors the world's seventh-largest metropolitan region, with 20 million people. Sabesp has been supplying sanitation and clean water to a growing share of them since its creation in 1973. Clean water is available to all residents of the municipalities it serves, while 76% of residents get their sewage treated.

The state government retains just over half of Sabesp shares, with the remainder split between equities traded in São Paulo and New York. The recent stock price values the company at about $10 billion, with another $4.5 billion in outstanding debt.

As Sabesp extended service to its region's populace, revenue grew, both from increases in water usage and rates. In 2012, revenue rose 8% to $5.5 billion, with earnings of about $3.50 per depositary share (excluding some non-operating gains). Dividend yield was 2.7%. Before now, Sabesp's tariff increases were able to keep pace with expenses, capital investment, and inflation (as shown in the top chart at left). The state-controlled company is committed to a $5 billion capital program to extend sanitation service to all regional residents by decade's end. To achieve that goal, Sabesp has doubled its annual capital spending in the past five years. Shareholders aren't getting lavish returns on those investments: Sabesp's $5 billion in capital investments over those five years have correlated with about $350 million in added cash flow. That's just a 7% pretax return and well below the 12% cost-of-capital that Sabesp's regulator uses for the utility.

THE WATER COMPANY wanted to raise its rates this coming September by about 13%, equivalent to $600 million, to fund capital spending. Regulators instead proposed an increase of just 2.35%, or $100 million. To offset the shortfall, they told Sabesp to cut operating expenses by 10%, or $300 million. "It's not feasible," said Sabesp's chief financial officer, Rui de Britto Alvares Affonso, on Wednesday's call. "It's not correct. In some cases, it's not legal." Unless regulators relent, the company will have to shrink operations, capital spending, or dividends.

The sudden squeeze on Brazil's utilities might surprise investors in the U.S., where utilities get a regulated return on capital they invest in plants. Sabesp doesn't own all the reservoirs it uses, and Brazilian utilities— including Sabesp—have sometimes seen their concessions canceled by mercurial government partners. Sabesp pays São Paulo $165 million a year for its water concession. The utility expected regulators to allow it to recover that annual payment from rate payers; regulators are waffling.

The Bottom Line

If lower rate increases become a reality, Sabesp's American depositary shares, recently in the $40s, would have a fair value in the $30s.

It's doubtful, under such capricious governance, that Brazilian utilities should be valued through the standard discounted cash-flow model, which assumes that cash will flow forever—as represented by some large "terminal value" tacked on at the end of the forecast period. Yet that's how some U.S. analysts judge Sabesp and its Brazilian peers. Modeling Sabesp's concession over 30 years with tariff increases of 5% in 2017, 2021, and 2025, and 3% thereafter, including its announced capital spending—but no terminal value—the cash-flow stream's discounted present value would be in the mid-$30s per depositary share. As an alternative measure, Sabesp's enterprise value is seven times its cash flow. That's 50% higher than the multiple of Brazil's electric utilities.

The irony, of course, is that if Brazil abuses its investor-owned utilities, it will have a tougher time raising capital to meet one of the government's stated goals: bringing its people universal electric and sanitation services.